These 4 Measures Indicate That Nan Nan Resources Enterprise (HKG:1229) Is Using Debt Extensively

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, Nan Nan Resources Enterprise Limited (HKG:1229) does carry debt. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Nan Nan Resources Enterprise

What Is Nan Nan Resources Enterprise's Debt?

As you can see below, at the end of September 2021, Nan Nan Resources Enterprise had HK$277.4m of debt, up from HK$152.5m a year ago. Click the image for more detail. On the flip side, it has HK$216.4m in cash leading to net debt of about HK$60.9m.

A Look At Nan Nan Resources Enterprise's Liabilities

We can see from the most recent balance sheet that Nan Nan Resources Enterprise had liabilities of HK$141.7m falling due within a year, and liabilities of HK$308.0m due beyond that. Offsetting this, it had HK$216.4m in cash and HK$4.54m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$228.8m.

This deficit casts a shadow over the HK$71.9m company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. At the end of the day, Nan Nan Resources Enterprise would probably need a major re-capitalization if its creditors were to demand repayment.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

With net debt sitting at just 0.72 times EBITDA, Nan Nan Resources Enterprise is arguably pretty conservatively geared. And it boasts interest cover of 7.2 times, which is more than adequate. Although Nan Nan Resources Enterprise made a loss at the EBIT level, last year, it was also good to see that it generated HK$65m in EBIT over the last twelve months. There's no doubt that we learn most about debt from the balance sheet. But it is Nan Nan Resources Enterprise's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Considering the last year, Nan Nan Resources Enterprise actually recorded a cash outflow, overall. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Our View

To be frank both Nan Nan Resources Enterprise's conversion of EBIT to free cash flow and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least it's pretty decent at managing its debt, based on its EBITDA,; that's encouraging. We're quite clear that we consider Nan Nan Resources Enterprise to be really rather risky, as a result of its balance sheet health. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 4 warning signs for Nan Nan Resources Enterprise (of which 2 are potentially serious!) you should know about.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.